What is Liquidity Coverage Ratio? Formula and Calculation
Liquidity Coverage Ratio or LCR is a term coined by financial regulators around the globe to describe the highly liquid assets required to be held in reserve by a bank or other lenders to meet short-term obligations and possess capital preservation.
This blog talks about how LCR is calculated and why it is important for businesses.
What is the Liquidity Coverage Ratio (LCR)?
The liquidity coverage ratio is the percentage of highly liquid assets set aside as a security by financial institutions to guarantee their continued capacity to pay short-term commitments.
This ratio seeks to buffer market-wide shocks and ensure that lenders have good capital preservation to withstand any short-term liquidity disruptions that may afflict the market.
In times of extreme volatility, such as during the financial crisis of 2008, regulators had concerns over banks’ ability to cope with sudden liquidity crises. This prompted them to tighten standards for liquidity management, which led to the formation of LCR in the Basel III Accord.
Under Basel III, a set of reform directives intended to improve regulation, supervision, and risk management in the international banking sector, banks must maintain high-quality liquid assets sufficient to cover cash withdrawals for 30 days.
Following the release of the Indian framework for LCR regulations on June 9, 2014, the Reserve Bank of India (RBI) introduced LCR on January 1, 2015.
LCR Ratio Formula
The liquidity coverage ratio formula is mentioned below:
LCR = (High-Quality Liquid Assets, i.e., HQLA)/(Total net cash outflows over the next 30 calendar days)
A high-quality liquid asset is any asset that can be quickly and readily converted into cash with little to no cost or value.
Also Read: What Is Liquidity Adjustment Facility And How Does It Impact The Indian Economy?
How is the Liquidity Coverage Ratio Calculated using an LCR Calculator?
Here’s how you can calculate liquid coverage ratio:
- First, enter the cash and cash equivalents that the lender has.
- The marketable securities of the lender must now be entered in the following stage. This will provide the total highly liquid assets.
- Further, enter the expected 30-days cash outflows.
- The calculator will now compute the LCR automatically within seconds.
Let’s understand this with an example
Let’s say that a bank has high-quality liquid assets worth Rs.60 crore and Rs.40 crore in anticipated net cash flows considering a 30-day stress period:
The bank’s LCR would be Rs.60 crore/Rs.40 crore = 1.5 or 150%.
Liquidity Coverage Ratio Requirements
In reaction to the 2008 financial crisis, pushed on by banks engaging in unethical banking practices and providing unsafe loans, the Basel Committee of Banking Supervision developed the LCR concept and standards in 2009.
Banks and insurance firms suffered losses from this activity, and investors started taking their money out of these businesses. Some sought bankruptcy protection, and the federal government helped them out.
A way to stop such situations from happening again in the future was the concept of LCR.
The goal of LCR is that central banks act as lenders of last resort rather than lenders of first resort, and banks must have a stable financial structure and maintain adequate liquid assets during normal times.
How to Interpret LCR?
A bank is considered to be in good financial condition when the LCR ratio is higher than 100%. However, if the ratio is less than 1:1, the bank may not possess adequate liquidity to pay for its ongoing business operations or to satisfy its short-term debts.
The recommended LCR ratio for banks is 1:1. However, this is challenging because it requires a bank to have enough liquid assets or cash at any given moment to last for the following thirty days.
Limitations of the Liquidity Coverage Ratio
Among the LCR’s drawbacks are:
- The LCR has the drawback of making banks store more cash, which may result in fewer loans to individuals and companies. One may contend that if banks offer fewer loans, the economy will expand more slowly because businesses that use debt to support operations and expansion will not have access to cash.
- The LCR’s ability to give banks an adequate financial cushion or whether it is sufficient to cover cash withdrawals for 30 days depends on when the next financial crisis occurs, which presents additional constraints.
Also Read: Liquidity Trap: Meaning, Causes and Indicators
Final Word
The liquidity coverage ratio (LCR) gauges how much cash and liquid assets banks ought to hold. Institutional and financial market stability is aided by this. When a crisis strikes, it offers liquid funds.
Every bank must comply with the Basel III Accord’s LCR requirements to pass its stress test, which is at 100%. This enforces that the banks have access to sufficient amounts of highly liquid assets to address a liquidity crisis within 30 days.
FAQs
Ans. The Basel III Accord stipulates that every bank must have an LCR greater than 100%. However, a greater LCR is often preferable as it shows that the bank can better satisfy its short-term liquidity demands.
Ans. Technically speaking, LCR can be applied to any industry. It is mainly pertinent to banks and insurance businesses, though. This is because these businesses are the guardians of other people’s money and are thus most susceptible to changes in the market and the overall economy.
Ans. The Basel Committee of Banking Supervision created the LCR concept and guidelines in 2009 to respond to the 2008 financial crisis, exacerbated by banks engaging in unethical banking practices and making risky loans.
Ans. The liquidity coverage ratio foresees market-wide shocks and ensures that financial institutions have adequate capital preservation to withstand any temporary interruptions in liquidity.
Ans. LCR can be negative mathematically. Instead of having highly liquid assets, though, it will imply that the banks would only have highly liquid liabilities. This will place the bank in a very dangerous situation.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
